June Carbone (left) and Bill Black (right), both of UMKC, and I were trading e-mails two days ago, and to make a long story short, on pretty short notice, I filled in (to substitute for a cancellation) on a panel in the Section on Socio-Economics workshop here at the AALS meeting on Wednesday afternoon, moderated by June, and on which Bill was presenting.

The general theme of the panel was "norm-creation." Bill's talk centered on a 2005 presentation by Michael Jensen, of SSRN and all sorts of other fame, about what Jensen now sees as "low-integrity relations" between firms and analysts on the subject of earnings smoothing. I have written and posted on the relationship between law and business ethics, so I also was interested in the Jensen piece.

Since my quickly prepared presentation consists presently of what I scrawled at lunch on some LexisNexis note paper, I thought this would be a good place to preserve this somewhat impromptu "symposium" offering.

Jensen's observations are thought-provoking, particularly if you have been on the inside of a corporation making decisions about how you report your earnings. Bill is a criminologist, and his piece was about what the criminologists call "neutralization" and what I would call "co-optation, in this instance into the creation of norms under which the manipulation of accounting numbers was acceptable.

My limited goal was to take a deeper dive into how we decide something is manipulation worthy of the name "lie" or "fraud." Regular readers of this blog are, I believe, familiar with my long history as a GC at the corporate and divisional level in companies that aspired (because of the career history of the managers) to something resembling GE management style. At AlliedSignal under Larry Bossidy, the mantra every year was "Make the Numbers," a shorthand (I came to believe poorly worded) for the values of "fulfill your commitments, do what you promise, and do that for customers, employees, shareholders." So if that was one end of the continuum driving the development of internal norms of behavior, the unacceptable other end of the continuum would have been "Make Up the Numbers."

There is an epistemological element to all of this, I'm sorry to say. Accounting, in many respects, is about buckets of time, quarters and years, most of which are arbitrary (or at least as arbitrary as the fact of the Gregorian calendar and its divisions). A goal of accounting (and I'm pretty sure I could pull up a basic accounting text on this) is to match revenues and costs properly in each bucket. Smoothing is the phenomenon by which companies deliberately manipulate the revenues and costs in the various buckets so as to conform to earlier predictions, either from management or analysts, about the result in the time periods represented by the buckets.

More on this below the fold.

In the pre-Enron period, there is no question that analysts
demanded, and companies delivered, if they could, no surprises from what the companies issued as their own earnings expectations for future periods.* That
was the point of smoothing. Bill had an interesting thesis about
those days: if the company's stock was punished because it missed an
estimate by a penny (out of saying several dollars per share of
earnings), it was because the market perceived that the company had
exhausted every possible "fraud and manipulation" and still couldn't
get to the number. I disagree, on further reflection, with that causal
explanation. I think the market expected you could always manipulate
another penny, so that if you missed by a penny, it was a deliberate
bearish signal by management on the future prospects.

But the present question is what it means to put the terms "lie" or
"fraud" as descriptors on that manipulation. I want to put aside the
straw man of straight cooking the books in the manner by which I now
confess I did my freshman chemistry lab reports: if you don't like the
number, erase it and put in a new one. Booking sales you never made is
out and out fraud. Simply changing entries you don't like is out and
out fraud. Writing an earlier date on an option agreement and pretending it was
signed then is a lie. Those cases, it seems to me, are too easy to be
interesting.

Here's the epistemology. If a lie is a sentence uttered
deliberately not to reflect reality, and with the intention of
deceiving in the process, what does it means to lie about your
accounting when you are talking about manipulation that is not out and
out falsification of a piece of data? A financial statement is itself
a model seeking to represent another reality - the state of a
business. That reality is so complex that we need to reflect it in
several ways, with a snap shot view at a moment in time (the balance
sheet), and in flow over periods (income and cash flow statements).
Lots of aspects of accounting conventions are precisely that:
conventions that are proxies and do not themselves reflect reality. If
you use a depreciation method, you are not really reflect the extent to
which the asset is used up; you are reflecting a model of that use.
And sometimes, the accounting or tax rules sanction what seems like a
lie: accelerated depreciation. So what are truth statements in the
context of accounting?

Moreover, the accounting conventions are subject to interpretation
and judgment. For example, is the cost fairly attributable to one
bucket or more than one bucket (i.e., do you expense or capitalize the
cost?)

So there is something of a gray area on that continuum, between
"Make the Numbers" and "Make Up the Numbers," in which we have to
struggle with questions of the very essence of truth.

Here are some very cursory hypotheses:

1. Certainly pre-Enron, the rules of the manager-analyst game
rewarded present period "making the numbers" over long-term value, or
at least that's how companies perceived it. Woe betide the R&D
department in the fourth quarter of a company having a bad year. Even
without manipulation of the accounting, as Jensen observes, there was a
double-think rationalization (in my view) of perfectly legal, but
economically nonsensical trading of long-term value for short-term
gain. See Larry Ribstein for why this supports the thesis that firms
are turning to the private capital markets.

2. There is more
transparency now than there used to be. That is partly related to
attitudinal shifts, and partly due to the Sarbanes-Oxley rules
(Regulation G) requiring there to be a reconciliation in publicly
released financial statements between GAAP numbers and "as adjusted for
continuing operations" numbers.

3. The integrity issues related to smoothing were not restricted to
the relationship between the firm, on one hand, and securities markets,
on the other. In large and complex organizations there is gaming up
and down the business: business unit controllers game the division,
and divisional controllers game the corporation. Jensen has another
paper (only downloaded about 7,500 times) entitled Paying People to Lie: The Truth About the Budgeting System. Here is the abstract:

This paper analyzes the
counterproductive effects associated with using budgets or targets in
an organization's performance measurement and compensation systems.
Paying people on the basis of how their performance relates to a budget
or target causes people to game the system and in doing so to destroy
value in two main ways: 1. both superiors and subordinates lie in the
formulation of budgets and therefore gut the budgeting process of the
critical unbiased information that is required to coordinate the
activities of disparate parts of an organization, and 2. they game the
realization of the budgets or targets and in doing so destroy value for
their organizations. Although most managers and analysts understand
that budget gaming is widespread, few understand the huge costs it
imposes on organizations and how to lower them.

My
purpose in this paper is to explain exactly how this happens and how
managers and firms can stop this counterproductive cycle. The key lies
not in destroying the budgeting systems, but in changing the way
organizations pay people. In particular to stop this highly
counterproductive behavior we must stop using budgets or targets in the
compensation formulas and promotion systems for employees and managers.
This means taking all kinks, discontinuities and non-linearities out of
the pay-for-performance profile of each employee and manager. Such
purely linear compensation formulas provide no incentives to lie, or to
withhold and distort information, or to game the system.

While
the evidence on the costs of these systems is not extensive, I believe
that solving the problems could easily result in large productivity and
value increases - sometimes as much as 50 to 100% improvements in
productivity. I believe the less intensive reliance on such
budget/target systems is an important cause of the increased
productivity of entrepreneurial and LBO firms. Moreover, eliminating
budget/target-induced gaming from the management system will eliminate
one of the major forces leading to the general loss of integrity in
organizations. People are taught to lie in these pervasive budgeting
systems because if they tell the truth they often get punished and if
they lie they get rewarded. Once taught to lie in this system people
generally cannot help but extend that behavior to all sorts of other
relationships in the organization.

For what it's worth, I watched this happen. I am not convinced that
people respond so directly to compensation that changing the pay system
would solve the problem, but I have no doubt that Jensen correctly
identifies a corrupting influence from a "top-down" imposed budgeting
system. I have this intuition that the gaming is more complex than merely economic. Once you set the rules of the game for success-oriented people, success-oriented people want to win. Or they want to get an A and not a C. Period.

* * *

This is about norms and integrity. My guess is the number of people who walk into these situations with the preconceived notion they are knowingly going to scheme is fairly small. That is, the set of true evil actors is relatively small. The set of banal evil, of cooptation, or neutralization, as Bill Black put, seems to me is not only bigger, but more interesting and important. And I've written about the dangers of the instrumental reasoning process by which we can delude or deceive ourselves into justifying the abuse, all of which can be exacerbated by a lawyer's professional gloss (if not imprimatur) on the justification.

I don't think the solutions are algorithmic. I am suspicious of instrumental reason (or instrumental reason masquerading as pure practical reason). I am aware of the mushiness of relying on intuition. So it's a mystery to me still how we resolve the intersection of legal rationalization with a moral and ethical sense.

*(The practice of issuing "guidance," as it is called, has substantially
curtailed since then, I think. I saw some data just a few days ago
that securities class action filings are down - that would be
consistent with less earnings guidance - the core of a archetypal suit
consists of company guidance and then a subsequent event that proves
the guidance incorrect.)